What is total cost of taxable accounts to compare with pre-tax accounts

[RobertBirnie]

Hi,

I am looking into opening a 457 account through my wife's work to expand out our pre-tax savings. But the choices are really bad, on the low end I estimate between 1.6% and 2% in fees per year. And its really hard to figure out exactly how much the costs are too because they try to hide it in all kinds of categories. .1% fund choice fee, .35% service fee, .8% fee for S&P500 fund, fee for broker, $10 yearly fee, unknown fee for advisor.... it goes on...

So I am looking to find a number that a taxable account is going to cost me to know if it is worth setting up this fee crazy account, or if I'm better off going solo. I know the actual fund fees would be super low as I'd go with Vanguard funds but I don't know what this means come tax time.  Also, at this point we've got 2 maxed 401ks and 2 maxed IRA accounts, so I don't even know if the extra savings in pre-tax accounts is useful.

Thoughts?

[capital]

You pay taxes on realized capital gains, which means when you sell the funds. If you just buy and hold rather than trading, you'll pay nothing until you sell or rebalance in the future.

[anotherAlias]

A slight correction on ehgee's post.  If you are investing in index funds in a taxable account, you will have to pay taxes on any dividends and on the capital gains that occur as a result of churn within the index.  How much you pay at tax time depends on what tax bracket you are in and how much you received in gains/dividends.

Personally, I like the moneychimp.com site for figuring out  taxes.  There are a couple diagrams that really helped me understand the tax treatment of different types of income.  That site also has a nice little calculator to help figure out your tax liability.

[matchewed]

The total costs are going to depend on a large number of factors. For a taxable account you'll have to determine as noted below, how much you will pay in dividend tax and capital gains tax. A quick wikipedia search will let you know what percentage that is.

As for the 457 plan you'll mainly be looking at fees as you yourself noted. It would be best to sit down with the plan documents and outline any fees associated with the plan itself. Then tackle each fund option and evaluate the prospectus where they have to detail what the fees are for the individual fund.

Once you've got all that hammered out then you need to determine whether the tax savings now is worth it. This isn't an evaluation of $1000 pre vs. $1000 post tax. That post tax amount is technically less due to the fact that you already had to pay some in taxes.

So to sum it up, it depends, if you're looking to optimize you'll need to run numbers for your individual scenario. If you're looking to reduce your income now the 457 will be the best bet.

[aj_yooper]

I have used a tax advantaged account (403b), which fortunately was low cost (Vanguard).  However, there is a point to consider a taxable account, especially when there are high fees in the tax advantaged.  In that case, you could contribute to get the employer's match, if any, and then do a Roth followed by taxable.  IMO, if you plan to retire in your current tax bracket, a tax advantaged account does not benefit much, if any, as you pay the same tax either now or later: 

tax rate*savings*(1 + annualized return)^number of years invested = tax rate* [savings*(1 + annualized return)^number of years invested}

If you plan to retire in a lower tax bracket, then the tax advantaged account transports your money to the new bracket, a very nice thing.

[xocotl]

I have used a tax advantaged account (403b), which fortunately was low cost (Vanguard).  However, there is a point to consider a taxable account, especially when there are high fees in the tax advantaged.  In that case, you could contribute to get the employer's match, if any, and then do a Roth followed by taxable.  IMO, if you plan to retire in your current tax bracket, a tax advantaged account does not benefit much, if any, as you pay the same tax either now or later: 

tax rate*savings*(1 + annualized return)^number of years invested = tax rate* [savings*(1 + annualized return)^number of years invested}

If you plan to retire in a lower tax bracket, then the tax advantaged account transports your money to the new bracket, a very nice thing.

Your equations are off. Even if you retire in the same tax bracket there is still a benefit to a tax advantaged account vs long term buy and hold in a taxable account. The amount you end up with in the tax advantaged account is:

IRAValue = (1 - tax rate later) * savings * (1 + annualized return) ^ number of years invested

Meanwhile for the taxable account you end up with:

TaxableValue = (1 - tax rate now) * savings + (1 - cap gains tax rate later) * (1 - tax rate now) * savings * ((1 + annualized return) ^ number of years invested - 1)

(Where [(1 - tax rate now) * savings] is the amount you deposit into the account, and then [(1 - tax rate now) * savings * ((1 + annualized return) ^ number of years invested - 1)] are your gains, which then get reduced by a factor of (1 - cap gains tax rate) when you realize them.)

If your marginal tax rate now vs later is the same, the tax-deferred account is a huge win (by a margin of the long term capital gains rate). If you have dividends/capital gains over the course of your holding period, the advantage of the IRA is even bigger.

I find an easier way to think about it is to note that if tax rates now and in the future are the same, then a traditional IRA and a Roth IRA are exactly the same. I.e. deferring your taxes is exactly the same as not having to pay taxes on your gains in terms of how much money you end up with.

Edited: Fixed some typos.

[RobertBirnie]

Thanks a lot for the help so far. I'll talk to the broker again and get the fees that they didn't have in the handouts. The formula's and links help a lot in getting this math figured out.

[aj_yooper]

I have used a tax advantaged account (403b), which fortunately was low cost (Vanguard).  However, there is a point to consider a taxable account, especially when there are high fees in the tax advantaged.  In that case, you could contribute to get the employer's match, if any, and then do a Roth followed by taxable.  IMO, if you plan to retire in your current tax bracket, a tax advantaged account does not benefit much, if any, as you pay the same tax either now or later: 

tax rate*savings*(1 + annualized return)^number of years invested = tax rate* [savings*(1 + annualized return)^number of years invested}

If you plan to retire in a lower tax bracket, then the tax advantaged account transports your money to the new bracket, a very nice thing.

Your equations are off. Even if you retire in the same tax bracket there is still a benefit to a tax advantaged account vs long term buy and hold in a taxable account. The amount you end up with in the tax advantaged account is:

IRAValue = (1 - tax rate later) * savings * (1 + annualized return) ^ number of years invested

Meanwhile for the taxable account you end up with:

TaxableValue = (1 - tax rate now) * savings + (1 - cap gains tax rate later) * (1 - tax rate now) * savings * ((1 + annualized return) ^ number of years invested - 1)

(Where [(1 - tax rate now) * savings] is the amount you deposit into the account, and then [(1 - tax rate now) * savings * ((1 + annualized return) ^ number of years invested - 1)] are your gains, which then get reduced by a factor of (1 - cap gains tax rate) when you realize them.)

If your marginal tax rate now vs later is the same, the tax-deferred account is a huge win (by a margin of the long term capital gains rate). If you have dividends/capital gains over the course of your holding period, the advantage of the IRA is even bigger.

I find an easier way to think about it is to note that if tax rates now and in the future are the same, then a traditional IRA and a Roth IRA are exactly the same. I.e. deferring your taxes is exactly the same as not having to pay taxes on your gains in terms of how much money you end up with.

Edited: Fixed some typos.

Thanks for the comments.  If you retire into a 15% tax bracket, capital gains is 0% so a taxable account is very helpful.  I was assuming most people retiring early would be in that bracket.  My bad.